Economic Substance Requirements for Labuan Entities

OECD background, key regulatory changes, substance schedules and tax treatment for Labuan entities.

The OECD Inclusive Framework, in follow-up work related to BEPS Action 5, has released new global standards that apply to "no or only nominal tax" jurisdictions and that require "substantial activities" in order for the tax regime not to be considered a "harmful tax practice". The objective is to prevent such low-tax jurisdictions from attracting profits from certain mobile activities without corresponding economic activity.

Overview

The types of mobile activities covered include headquarters, distribution centres, service centres, financing, leasing, fund management, banking, insurance, shipping, holding companies, and the provision of intangibles.

Taxpayers should monitor how each relevant jurisdiction implements the new substance requirements (both law changes and future regulations) and be prepared to demonstrate that certain "core income generating activities" are occurring within low-tax jurisdictions commensurate with the profits being reported in those jurisdictions.

Important: failure to satisfy the substantial activities requirements may result in other countries taking certain "defensive measures" in response, which could include denying deductions, imposing withholding taxes on payments to companies in such jurisdictions, or applying controlled foreign corporation rules to subsidiaries in such jurisdictions.

New Development: Tax Framework in Labuan

Recent developments to tax laws for Labuan entities have seen the introduction of new regulations to enhance the reputation and credibility of the tax regime in Labuan. The changes are welcomed as Malaysia seeks to implement the minimum standards under the Base Erosion and Profit Shifting (BEPS) Action Plan.

Key Changes to the LBATA

Labuan business activity: the definition of "Labuan business activity" was amended to remove Malaysian ringgit restrictions or restrictions on dealing with Malaysian residents.

Economic substance requirements (ESR): Section 2B(1)(b)(i) of the LBATA requires Labuan entities, for trading activities, to have an adequate number of full-time employees in Labuan and an adequate amount of annual operating expenditure in Labuan. For non-trading activities, additional control and management requirements in Labuan apply.

Exclusion of IP rights income: any income derived from royalty and other income derived from intellectual property rights is subject to tax at 17% or 24% under the Income Tax Act 1967.

Removal of the RM20,000 option: Labuan entities carrying on a trading activity no longer have the option to elect to pay tax of RM20,000. All Labuan entities that comply with the relevant economic substance requirements shall be subject to tax at 3% on chargeable profits.

Non-complying ESR: a Labuan entity carrying on a Labuan business activity but failing to comply with the relevant substance requirements is subject to tax at 24% of its chargeable profits.

Non-Deductibility

With effect from 1 January 2019, certain payments made to a Labuan entity by a Malaysian resident company are not entitled to a full tax deduction:

  • Interest payment: 25% not allowed for deduction.
  • Lease rental: 25% not allowed for deduction.
  • Other payments: 97% not allowed for deduction.

Substance Requirements Schedule

A Labuan entity carrying on a Labuan business activity is only subject to tax at the rate of 3% or 0% of the net profit provided that it has fulfilled the requirement of the number of full-time employees and an amount of annual operating expenditure as specified below:

  • Labuan insurer, reinsurer, takaful operator or retakaful operator: 3 FTE, RM 200,000 OPEX.
  • Labuan underwriting manager or underwriting takaful manager: 4 FTE, RM 100,000 OPEX.
  • Labuan insurance manager or takaful manager: 4 FTE, RM 100,000 OPEX.
  • Labuan insurance broker or takaful broker: 2 FTE, RM 100,000 OPEX.
  • Labuan first party captive insurer or captive takaful: 2 FTE, RM 100,000 OPEX.
  • Labuan third party captive insurer or captive takaful: 2 FTE, RM 100,000 OPEX.
  • Labuan International Commodity Trading Company: 3 FTE, RM 3,000,000 OPEX.
  • Labuan bank, investment bank, Islamic bank or Islamic investment bank: 3 FTE, RM 200,000 OPEX.
  • Labuan trust company: 3 FTE, RM 120,000 OPEX.
  • Labuan leasing company (10 or less related companies): 2 per group, RM 100,000 each.
  • Labuan leasing company (11 to 20 related companies): 3 per group, RM 100,000 each.
  • Labuan leasing company (21 to 30 related companies): 4 per group, RM 100,000 each.
  • Labuan leasing company (more than 30 related companies): +1 per 10 additional, RM 100,000 each.
  • Labuan credit token company: 2 FTE, RM 100,000 OPEX.
  • Labuan development finance company: 2 FTE, RM 100,000 OPEX.
  • Labuan building credit company: 2 FTE, RM 100,000 OPEX.
  • Labuan factoring company: 2 FTE, RM 100,000 OPEX.
  • Labuan money broker: 2 FTE, RM 100,000 OPEX.
  • Labuan fund manager: 2 FTE, RM 100,000 OPEX.
  • Labuan securities licensee: 2 FTE, RM 100,000 OPEX.
  • Labuan fund administrator: 2 FTE, RM 100,000 OPEX.
  • Labuan company management (Section 129 LFSSA): 2 FTE, RM 100,000 OPEX.
  • Labuan International Financial Exchange: 2 FTE, RM 120,000 OPEX.
  • Self-regulatory organisation: 2 FTE, RM 120,000 OPEX.
  • Investment holding (other than pure equity): 1 FTE, RM 20,000 OPEX.
  • Pure equity holding activities: exempted from the FTE requirement, RM 20,000 OPEX.
  • Administrative, accounting, legal, backroom, payroll, talent management, agency, insolvency and management services: 2 FTE, RM 50,000 OPEX.

FTE means full-time employees. OPEX means operating expenditure. Pure equity holding entities are exempted from the full-time employee requirement, but must convene a board meeting in Labuan at least once a year, have a registered office in Labuan, appoint a secretary resident in Labuan, and keep accounting and business records in Labuan.

Summary of Tax Treatment

  • Entity A carries on trading and non-trading activity, complies for non-trading but not for trading: taxed at 24%.
  • Entity B carries on trading and non-trading activity, complies for trading but not for non-trading: taxed at 3%.
  • Entity C carries on trading activity and complies: taxed at 3%.
  • Entity D carries on trading activity and does not comply: taxed at 24%.
  • Entity E carries on non-trading activity and complies: taxed at 0%.
  • Entity F carries on non-trading activity and does not comply: taxed at 24%.

Subsection 2(2) of the LBATA provides that where a Labuan entity carries on both a Labuan trading activity and a Labuan non-trading activity, such entity shall be deemed to be carrying on a Labuan trading activity.

Conclusion: Labuan IBFC continues to introduce necessary changes to its laws and regulations to remain both reputable and competitive. Businesses would do well to look at whether their existing structures are in compliance with the new requirements.

For related reading, see our whitepaper on the recent developments in the Labuan tax framework and our overview of the Labuan Business Activity Tax.

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